Inflation Targeting

The act of influencing the level of prices in an economy through the use of several monetary policy tools

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Written by CFI Team

What is Inflation Targeting?

Inflation targeting is a common practice among central banks globally that aims to influence the level of prices in an economy through the use of several monetary policy tools.

Inflation Targeting

Summary

Inflation targeting is common among most central banks, with the Bank of Japan and the U.S. Federal Reserve being important exceptions.
The main tools used for inflation targeting are interest rates, reserve requirements, and open-market transactions.
To successfully pursue their inflation targets, central banks should be independent, credible, and transparent.

Creation of the Inflation-Targeting Framework

The inflation-targeting framework currently implemented among most central banks was developed in New Zealand in 1988-89 when the Reserve Bank of New Zealand was given the target of an inflation rate in the 0%-2% range and the operational independence to pursue it.

The framework was then copied by other countries and inflation targeting became an increasingly common goal. Inflation targeting was adopted in Chile and Canada in 1990, in Israel and the United Kingdom in 1991, and in many other countries in the following years.

Important Exceptions to Inflation-Targeting Approaches

While inflation targeting is a common goal among most central banks, two important central banks actually don’t target a specific level of inflation – the Bank of Japan and the U.S. Federal Reserve.

The Bank of Japan doesn’t officially target a specific level of inflation. That’s because inflation targeting is generally seen as a tool to fight inflation, while Japan faced deflationary pressures for decades.

The Federal Reserve doesn’t target a specific level of inflation, as it’s generally focused on a broader set of goals that are considered important – maximum employment, stable prices, and moderate long-term interest rates.

Main Tools Used for Inflation Targeting

Official interest rates set by the central bank can influence inflation. Lower interest rates are meant to help increase inflation, while higher interest rates are meant to be deflationary.

Changes in reserve requirements on deposits are another monetary policy tool used to control the number of loans in the economic system, which affects consumer purchases and, ultimately, inflation.

Open market transactions are also used to influence the level of prices, as they are meant to increase or decrease the money supply in the system. A higher (lower) money supply, other conditions held equal, is considered to be inflationary (deflationary).

Inflation Targeting - Tools

Key Factors for Success

In order to properly and successfully pursue its inflation targeting goal, a central bank must possess three important characteristics – independence, credibility, and transparency.

1. Central bank independence

If central banks are not independent, monetary policies may be influenced by short-term political interests that can be inconsistent with the inflation goals. For example, politicians may try to stimulate the economy with several monetary tools hoping for reelection, which can lead to higher inflation and failure in reaching the inflation targets previously set.

That’s why it’s a common belief that central banks should remain operationally independent. Moreover, some central banks also target independence, which means they set their own inflation targets.

2. Central bank’s credibility

In some cases, inflation targets may be inconsistent with other macroeconomic conditions. For example, a heavily indebted country that is aiming for a very low level of inflation may not be credible, as it could be in the government’s interest to resort to a higher inflation rate to dilute the real value of debt.

3. Central bank’s transparency

The concept of transparency is connected to that of credibility. A central bank that is not transparent in its decisions will ultimately lose credibility. That’s why many central banks produce quarterly reports, where they discuss the state of the economy and the trends in variables, such as money supply, securities markets, gross domestic product (GDP), employment, and prices.

4. Self-fulfillment of inflation-targeting policies

In some cases, inflation targeting measured by credible entities may be self-fulfilling. If people believe that the central bank will reach its inflation target, they start to act accordingly. For example, workers may require wage increases, at least in line with the expected inflation target, which will ultimately lead inflation towards that level.

Inflation Targeting in Today’s Economy

Price stability is a common goal among central banks globally. Inflation-targeting policies are generally the foundation of macroeconomic and monetary policy.

There is a common belief among most central bankers and governments that the best way to ensure price stability or a controlled level of inflation is to set an inflation target and reach it through the use of monetary policy tools. The tools include interest rates, reserve requirements, and open-market transactions.

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